C Corporations, Deduction Limits, 404(k) Dividends, and Reasonable Compensation

There are times when the amount of loan payments that a company would like to pay on its ESOP loan are greater than the Internal Revenue Code Section 404 deduction limits. One strategy is to see if you are able to deduct 50% under IRC Section 404. Another strategy is to use dividends.

404(k) Deduction Rules

If you are a C Corporation, a dividend is deductible under IRC Section 404(k) - Deduction for dividends paid on certain employer securities if the dividend:

"(i) is paid in cash to the participants in the plan or their beneficiaries,

"(ii) is paid to the plan and is distributed in cash to participants in the plan or their beneficiaries not later than 90 days after the close of the plan year in which paid,

"(iii) is, at the election of such participants or their beneficiaries—

(I) payable as provided in clause (i) or (ii), or

(II) paid to the plan and reinvested in qualifying employer securities, or

"(iv) is used to make payments on a loan described in IRC Section 404(a)(9)(A) - Certain contributions to employee stock ownership plans the proceeds of which were used to acquire the employer securities (whether or not allocated to participants) with respect to which the dividend is paid. "

Dividends Must be Reasonable

Of course, there are limits to the amount of dividends that you can pay. To be deductible, IRC Section 404(k)(5)((A) provides that dividends must be reasonable and not constitute an avoidance or evasion of taxation. Unfortunately, the IRS has not defined the meaning of reasonable. Instead, the IRS determines the reasonableness on a facts and circumstances basis, including factors such as the percentage of total compensation, whether the company can continue to pay the same dividends on a regular basis, and whether the dividends are comparable to dividends paid by similar publicly traded companies in the industry.

IRS Examination Steps

Internal Revenue Manual (IRM) 4.72.4, Employee Plans Technical Guidance, Employee Stock Ownership Plans (ESOPs) provides the following 404(k) deduction examination steps:

1. Cancelled checks, payroll records, trust receipts and disbursement records, and participant's accounts should be examined to determine that the IRC 404 limits have not been violated. Problems could also arise if the number of participants decreased so as to lower the deductible limits.
   
2. Look at the applicable question on Schedule E, ESOP Annual Information, of Form 5500, to find out whether the employer repaid the exempt loan using dividends on employer securities.
   
3. Look at the question on Schedule E with regard to whether any dividends used to repay an exempt loan were not generated by employer securities acquired in that exempt loan. If the answer is yes, find out if the employer securities paying those dividends were acquired after 8/4/89. If yes, disallow the deduction.
   
4. Determine whether the amount of dividends paid exceed the employer's current or accumulated earnings or profits under IRC 316. Review the question on Schedule E of Form 5500 for this information. If yes, disallow the deduction. [Here is a link to IRC Section 316 – Dividends defined]
   
5. Check whether the dividends paid on employer securities held by the ESOP are reasonable. A reasonable dividend does not include an unusually large dividend used to repay ESOP debt which is greatly in excess of the dividend the ESOP sponsor can reasonably be expected to pay on a recurring basis.
   
6. Determine whether any corporate redemptions of ESOP stock were deducted under IRC 404(k). If yes, disallow the deduction.

For more information, please read Dividends and S Corporation Distributions of Earnings

Proposed Federal Agency to Promote Shared Capitalism

The creation of a new federal agency to promote shared capitalism in America is discussed in Prominent Harvard University Economics Professor Calls for Government Promotion of Shared Capitalism, Including ESOPs in His Book:

"This proposed new federal agency would essentially gather information, publicize best practices, and assist firms that choose to participate in shared capitalism programs as described by Dr. Freeman in his book."

According to the Employee Ownership Blog, the new agency is proposed by Professor Richard B. Freeman, Chair of the Economics Department at Harvard University and Director of the Labor Studies Program at the National Bureau of Economic Research, on page 146 of his book, America Works: Critical Thoughts on the Exceptional U.S. Labor Market. This book discussion tells more about his proposed reforms:

"His proposed reform has nine components, all of which he contended will support continued prosperity, but will limit the growth of inequality by increasing taxes paid by the super-rich. A few notable solutions include more research and development, especially for the sciences, more worker decision-making and organization, better pensions and health care, distribution of stock options to all a company's employees, and the certification of corporate board members."

The post also discusses statistics on shared capitalism:

• Out of 114 million people in the U.S. who work in the private sector, 17.5% of employees own company stock, about 20 million employees, and 9.3% hold stock options, approximately 10 million employees.
  
• The number of employees who reported profit sharing, gainsharing, owning company stock or holding stock options was 46.7%, which is an increase over the 2002 GSS finding of 43.1%.
  
• While the data reflect a slight drop from the 2002 results which showed that 21.2% of employees owned company stock and 13.1% held stock options, the numbers are still impressive when one takes into consideration that almost 50% of the individuals working in the private sector are involved in some sort of shared capitalism program.

Here are some related posts on shared capitalism and the General Social Survey (GSS):

Shared Capitalism

Employee Ownership - A Key to Decreasing the Gap between the Rich and Poor

No One Plans to Fail, But Fails to Plan

Business Owner Should Plan for the Unexpected ; Develop a Succession Strategy discusses five possibilities for business continuation to ensure that the business owner's family and heirs share in the wealth of the company when the business owner is no longer around:

• Family succession – "Statistically only 30 percent of family businesses survive the second generation." Plan ahead to ensure the next generation has the skills necessary to succeed.
  
• Employees can take over the business – An ESOP is a vehicle to employee ownership and provides the owner and their heirs with fair market value.
  
• Stockholder, partnership or operating agreements that address death, disability and disengagement – This option provides a contingency plan for some of the worst-case scenarios.
  
• The sale of a business to a third party – It is important to plan for this option to get favorable terms, as the ""fire sale" prices never satisfy the surviving family."
  
• Sale through an initial public offering – This option "is never achieved soon after a business owner dies, becomes disabled or retires unless the IPO planning is very far along."

The premise of the article is to make sure you make succession planning a priority, or as the article puts it, "no one plans to fail, but fails to plan". Check out this post for more information on succession planning: Benefits of Succession Planning

Five Ways to Act Like Owners

Your Employees: Five Ways to Get Them Acting Like Owners discusses five ways to "foster an
entrepreneurial spirit throughout your organization":

• Correct errors of commission; punish errors of omission.
  
• Don't be a control freak with ADD.
  
• Reward actions and efforts beyond results.
  
• Support champions, long shots, and rebels.
  
• Identify and reward those doing right for the business.

I hope everyone has a happy and safe Thanksgiving weekend.

2007 End of Year Checklists

2007 End of Year Plan Sponsor “To Do” Lists is a document that provides a checklist of items to address by the plan sponsor by the end of the year. If you have a different plan year, some of the due dates will be different.

• All Qualified Plans list
  
  
• Adopt Design Changes by End of Plan Year
  
• Adopt EGTRRA Restatement if in Cycle B
  
• Adopt Katrina, Wilma, and Rita Distribution/Loan Amendments
  
• Review 2008 Plan Limits
  
• Comply with the Final Section 415 Regulations
  
• Increase Maximum Bond if Plan Holds Employer Securities
  
• Distributions Can be Directly Rolled Over to Roth IRAs
  
  
• 401(k) Plans list
  
  
  • All Qualified Plans list
    
  • Provide 401(k)/401(m) Safeharbor Notice by December 2, 2007 for Calendar Year Plans
    
  • Review 401(k) Definition of Compensation
    
  • Consider New Default Investment Safe Harbor
    
  • Comply with New Benefit Statement Requirement
    
  • Consider Adding Qualified Automatic Contribution Arrangement to Plan
    
  • Consider Increasing Period During which Excess Contributions May be Returned
    
    
• Other Defined Contribution Plans list
  
  
  • All Qualified Plans list
    
  • Comply with New Benefit Statement Requirement
    
  • Consider Impact of Low Normal Retirement Age Regulations on Money Purchase Pension Plans
    
  • Add 75% Annuity Option to Money Purchase Pension Plans
    
    
• Executive Compensation list
  
  
• Year End Deadline to Make Certain Elections under Nonqualified Deferred Compensation Plans
  
• Identify Plans Subject to the New Section 409A Nonqualified Deferred Compensation Rules
  
• Review Stock Option Grant Procedures for Upcoming Grants
  

The document also contains checklists for defined benefit plans and health and welfare plans and includes additional information on some of the recent rules and regulations.

Employee Ownership is Good for Vermont

MY TURN: Employee ownership helps sustain Vermont's economy is an opinion piece that tells how employee ownership is good for Vermont:

• Good for communities
  
• Good for business
  
• Good for selling owners
  
• Good for employees

The editorial also recommends that employee ownership be considered several times throughout the life of a company:

"While employee ownership will not suit every situation, it is an option that should at least be considered at several points in the life of a company: when a retiring owner needs to be bought out, when financing is needed for expansion, when there is a need to engage employees more fully in their work, as well as at start-up or in the very early stages of a company's growth."

Section 415 Changes/Record Number of Attendees

The November 15, 2007 Employee Ownership Update is online and discusses the following:

• Nominate a Company—or Your Company—for the Wall Street Journal Winning Workplaces Award
  
• SEC Looking at 10b5-1 Plans
  
• Final 415 Regulations Contain a Few Surprises
  
• California Revises Securities Requirements for Equity Compensation
  

Yesterday we discussed the Winning Workplaces Awards. The Update provides a link to nominate your own or another company.

The Update also notes some changes to Section 415:

"First, the definition of annual compensation has been clarified to include post-severance payments paid within 2 1/2 months following severance or the end of the limitation year. Regular pay, overtime, bonuses, commissions, etc., must be counted, but other forms of payments, such as for accrued sick leave or military service, are optional. Other types of severance pay, including parachute payments, deferred compensation triggered by severance, and severance pay itself, are not included. In a significant change, the rules state that the annual addition dollar amount must be prorated if the plan is terminated before the end of the limitation year."

For more information on the final Section 415 regulations, check out this link: T.D. 9319 - 72 Fed. Reg. 16878 (April 5, 2007) - Limitations on Benefits and Contributions Under Qualified Plans (IRC Section 415 Final Regulations)

Finally, the Update also discusses how the SEC is looking at 10b5-1 plans and some revisions to California's securities requirements for equity compensation. Check out Programmed stock trading plans eyed for more information on 10b5-1 plans.

Record Number of Attendees

Earlier this week we discussed the 2007 Las Vegas Conference & Trade Show. 2007 Las Vegas Conference & Tradeshow – What's the Buzz? confirms that there were approximately 1,230 attendees at the conference.

The Connection between Employee Engagement and the Bottom Line

Best Bosses - Five leaders who use innovative strategies and rewards to motivate employees notes that 14 of the 18 Best Bosses are employee-owned and provides a link to five examples:

"You can offer all the benefits in the world, but the one that matters most to employees is a piece of the action. Of the 18 honorees in Winning Workplaces' fourth annual Best Bosses competition, 14 run companies partly or completely worker-owned."

The results of the Winning Workplaces' fourth annual Best Bosses competition, which were announced in September of 2006, found that open-book management and financial education were found in 17 of the 18 winners:

"When employees have a sense of ownership and know that they can contribute directly to the outcome, it is easier for them to become directly engaged," says Mary Corbitt Clark, Executive Director of Winning Workplaces. "The Best Bosses understand the connection between employee engagement and the bottom line." Revenue growth jumped on average 40% last year among the 17 for-profit honorees. What's more, the Best Bosses are pulling back the curtain on financial and operating results for employees. Of the 18 winners, 17 Bosses practice "open-book management" and are teaching employees how to read and understand financial documents.

Elaine Pofeldt, senior editor of FORTUNE Small Business, notes the wide range of Best Bosses' attributes and the common-sense practices they promote. "They are listening carefully to their workers and giving them what they want: opportunities to educate themselves continually; the chance to work alongside the best people in their fields; benefits that ease the complex demands of their lives outside of work and a chance to give back to the community in more than a token way. These bosses k how to recognize their teams' achievements in creative and memorable ways."

According to the Winning Workplaces website, The Best Bosses Award program ran from 2003-2006 and has been replaced with the Top Small Workplaces program. We most recently discussed the 2007 Top Small Workplaces in this post: More Top Small Workplaces Coverage/Employee Ownership Month

Employee Ownership Cynics

Anyone who has worked in an ESOP company, or any company for that matter, has worked with cynics. Dealing with cynics is essential to developing and maintaining an ownership culture. The Cynicism Challenge defines ideological cynics as those that "reject employee ownership at a conceptual level" and situational cynics as those who "support the idea of ownership, but not the way in which their company implements it." It states that, in a typical company, 25% of employees are situational cynics and 5% are ideological cynics, and discusses the performance of cynics:

"ideological cynics seem to work less diligently and with less mental engagement than the typical employee. Situational cynics work as hard as the typical employee, but they are less likely to contribute to the company beyond the boundaries of their job description."

The article also focuses on ways to respond to cynics and concludes that the best to minimize cynicism is to prevent it before it starts:

• Manage Expectations
  
• Focus on Middle Managers
  
• Education
  
• Communication
• Ideological Cynics

Steve Sheppard's latest post discusses the cynics he has encountered as he speaks at ESOP Association Chapter gatherings or at private company celebrations. He compares these cynics to the cynics he encountered when he was a part of an ESOP company:

"That's when it dawned on me that the feeling was the same one I had experienced from time to time in our own ESOP company, when a member of the firm somehow didn't "get it," failed to understand the critical messages of collaboration, personal commitment, contribution, entrepreneurial risk-taking, being part of something bigger than one's self, and how to maximize the unique ESOP opportunity. Try as we might, managers and co-workers were not always successful in convincing some people that the ESOP contained a greater chance at success than in many other firms. Such individuals were not to be won over."

He points out that winning over all the cynics may not be possible:

"As I lamented the unpleasant comments directed at my presentation, I realized that 100% is sometimes not realistic. There will be people in an audience who just plain don't care for the sound of your voice or the intrusions upon their own comfort zones. And the same is true in our ESOPs: some simply do not want to go where we are headed. We owe it to every member of our companies to describe the vision and the anticipated roadmap of where we're going. We have to encourage, entice, enthuse and educate in the very best way we can. But at the end of the day, individuals still have to make their own choices about whether they like the message and direction or not. When their determination is that the ideas don't resonate or motivate, it's best to move on, for both parties. I always felt badly about those members of our company who never seemed to grasp what we were trying to do and who therefore didn't fit, but I couldn't let those attitudes speak for the whole entity."

2007 Las Vegas Conference & Trade Show

I attended the ESOP Association's 2007 Las Vegas Conference & Trade Show last week.
This year's record-setting attendance was over 1,200. The conference provides an excellent opportunity to stay current on ESOP issues and to network with ESOP companies and professionals. This year was no exception.

Dr. J. Robert Beyster delivered the keynote address on Thursday:

"The subject I will present is "Beyond the ESOP," and my message will be that there is more to employee ownership than just ESOPs. We employed a variety of different equity sharing techniques at SAIC to achieve our goals of widespread employee ownership."

He shared his afterthoughts in Small Business Challenges.

On Friday, ESOP Association President Michael Keeling provided his "Commentary on Pending ESOP Legislation and Potential Impact on ESOPs". The Rangel Proposal was a major focus of the commentary, including the negative impact it would have on S Corporations with synthetic equity and future S Corporation ESOP candidates. Most importantly, he stressed that all ESOPs should be concerned about this proposal, regardless of whether or not they are directly impacted by it.

Employee Retention Ideas

Points for Retention provides some great ideas about retaining valuable employees:

• "Re-recruit top performers before they get a better offer."
  
• "Implement a comprehensive mentoring program."
  
• "Offer better career visibility."
  
• "Explore various work options for retirement-age employees.
  
• "Use explicit ranking systems tied to incentives."
  
• "Consider changes in managerial style to accommodate younger workers."
  
• "Emphasize cross-training and diverse experiences to build skills and maintain employee interest."
  
• "Plan for succession and knowledge transfer."
  
• "Broaden the concept of retention. "
  

Partners Unplug and Recharge discusses an effective program one firm uses to ensure their key employees are taking a vacation:

"Don't use the excuse "I'm too busy to take a vacation" at one Missouri-based accounting and financial services firm.

BKD LLP of Springfield, Mo., requires partners to take a one-month paid sabbatical every five years.

Randy Hultz, BKD's director of human resources, said the time off not only allows partners to recover from the demands of client service and continually building professional expertise, but also serves as a teambuilding exercise.

"When a partner is away, he or she learns what the rest of the team can do. For team members, it's a chance to show they can handle extra responsibilities. That enables a company to consider succession planning by identifying the next generation of partners," Hultz said.

Tempted to work from home? Don't even think about it—partners on sabbatical have their e-mail accounts disabled."

Baby Boomers Selling to ESOPs

Want to Buy a Business? Your Timing is Right expands on yesterday's post titled Why the Number of ESOPs is not Growing at a Faster Rate, discussing the following:

• "Expect a glut of firms to go up for sale as thousands of baby boomers retire"
  
• "Most firms will sell to strangers"
  
• "Owners without an exit strategy will likely sell at a discount"
  
• "Expert advice is a must"
  
• "One option that's growing more popular is selling to employees"

In yesterday's post I attempted to quantify the potential universe of baby boomers looking to exit the business. The article estimates that by 2009, "750,000 companies owned by boomers -- one in every six -- will be looking for buyers, up fifteen-fold from 2001." The article also specifically mentions ESOPs as an option:

"One option that's growing more popular is selling to employees -- either a management buyout or employee stock ownership plan (ESOP). Both take time to set up but give owners the fulfillment that they're passing on their legacy…An ESOP tends to be a good route for firms with stable earnings and revenue. But the plan gets way too costly for small firms -- those under $1 million in yearly pre-tax profit -- due to associated upkeep costs like annual appraisals."

Why the Number of ESOPs is not Growing at a Faster Rate

Something caught my eye as I was reading the October 2007 ESOP Report. The President's page discussed the new goal added to the ESOP Association's Strategic Plan:

"Goal: Ownership – the Association will strive to increase broad-based employee ownership through ESOPs in America."

This was something that was fresh on my mind, as I just had spent part of my Friday presenting an introduction to ESOPs to a group of financial advisors (more on this later). I was also preparing to respond to a reader, who asked why, despite the many tax advantages provided by Congress, is there still less than 10,000 ESOPs. The new goal, my presentation on Friday, and the reader's question are all related. As a member of the ESOP Association, an ESOP consultant, and as a US citizen who understands the many benefits that ESOPs provide employees, companies, and society, here are some reasons why the number of ESOPs is not growing at a faster rate.

Many ESOP companies are acquired (with the ESOP being terminated) due to the success of the company, ultimately decreasing the number of ESOP companies

It's hard to be upset when employees of an ESOP company are financially rewarded for the results of their hard work and dedication to their company. We recently discussed an ESOP company acquisition, providing more the 600 participants with an average of more than $600,000 per participant. Acquisition is a by-product of the success of ESOP companies and one that will increase as the number of ESOP companies increases. According to a survey studying the reasons companies terminate their ESOP, acquisition was the most common reason cited for ESOP termination. Most acquired companies reported strong or very strong performance. This is consistent with a recent Employee Ownership Foundation survey and with research on employee ownership and corporate performance that demonstrates how ESOP companies grow faster than their non-ESOP counterparts.

Despite ESOP acquisitions, the number of ESOPs is still increasing

The number of ESOPs increased by 4.6% in 2006 from 9,225 to 9,650. Yes, even considering the ESOP acquisitions discussed above, the number of ESOPs is still increasing. While the number of ESOPs continues to slowly increase, we need to look for more reasons why the ESOP growth rate is so low.

Many companies and professional advisors are unaware of the benefits of ESOPs

The hard work of organizations like the ESOP Association and the National Center for Employee Ownership (NCEO) has increased ESOP awareness. However, I think it is safe to say that ESOPs are not mainstream and we need to continue educating companies and the business community about the benefits of ESOPs.

As I discussed above, I spent Friday sharing the benefits of ESOPs with a group of financial advisors. Why is this important? Many professional advisors (e.g. accountants, attorneys, and financial advisors) are also not familiar with the benefits of ESOPs. Companies are relying on these professional advisors to assist them in determining how to exit the company. If the professionals are not suggesting an ESOP as a legitimate alternative, it is less likely that the company will seriously consider implementing an ESOP.

Many professional advisors without ESOP expertise will lean towards business transition alternatives that allow them to share their expertise and receive compensation for it

Even if professional advisors are aware of the benefits of ESOPs, they may feel that they will be unable to assist their clients with the implementation of an ESOP. Since a major goal of a professional advisor is to share their expertise and receive compensation for it, they are likely to look for other business transition alternatives where they can utilize their expertise. As a result, there are situations where an ESOP might be a great fit but is not seriously considered. I am not questioning the integrity of these very competent professionals; rather, I am identifying a legitimate barrier to increasing the ESOP growth rate.

Many companies are not performing any type of succession planning and other business transition alternatives are being implemented as a result

A recent PricewaterhouseCoopers survey found that 30% of CEOs do not have a plan in place. The number increases to 53% for family-owned businesses. The survey also found that the majority of companies, including many of those that do not have a succession plan, think they will end up selling to a third party. If more business owners took the time to identify their estate and succession planning objectives and considered all of their alternatives, many would find an ESOP to be a great fit for their situation.

With the baby boomers starting to reach retirement age and looking to exit the business, now is the time to increase the ESOP growth rate

This year the first baby boomer reached retirement age. While I could not locate a reliable source document, the statistics I found seem to indicate that more than 5 million companies (UPDATED 3/2/08) will be looking to transition the ownership of their company in the next five to 20 years. If we intend to increase the ESOP growth rate, it is essential that the baby boomers looking for a way to exit the business understand the benefits of ESOPs and seriously consider an ESOP as a viable option.

There is some good news – more companies appear to be implementing ESOPs

Here are three recent examples:

1. Five of the 15 Wall Street Journal's Top Small Workplaces have significant employee ownership, including four with ESOPs.
   
2. 22.3% of the Inc. 5000 Index companies state that selling to an ESOP is a Likely Strategy for Transferring Ownership.
   
3. A PricewaterhouseCoopers' "Trendsetter Barometer" survey found that
   19% of CEOs of fastest-growing private companies plan to include an ESOP in their exit plan.

Just a Start

This post does not provide all of the answers. In fact, it probably raises more questions than it provides answers. I hope my post sparks a discussion about why the number of ESOPs is not growing at a faster rate and what actions need to be taken to increase the growth rate. Please let me know what you think.

The Economic Performance of ESOP Companies

Economic Performance of ESOP Companies discusses the results of the Employee Ownership Foundation's 16th Annual ESOP Economic Performance Survey, which we previously discussed in Creating an ESOP is a Good Business Decision:

"We've always said the economic performance of ESOP companies surpassed that of non-ESOP companies, in fact, we have results to prove it. In 2007, over 89% of ESOP companies responding to an annual survey conducted by the Employee Ownership Foundation stated that the ESOP was good for business. The same can be said for the last few years with corresponding numbers respectively at 91% in 2006, 87.5% in 2005 and 88% in 2004.

While we know that comparing the performance of an ESOP companies stock to that of the stock market is an apples and organs comparison, but we find it to be a good indicator of performance. In 2007 41% stated that the company did better than three indices, the Dow Jones Industrial Average, S & P 500, and the NASDAQ."

In The News: Annual Company Meeting/Making It Easier To Sell The Company

Modern Group Ltd. (Bristol, PA)

Taking stock of what's important discusses Modern Group Ltd., a 600-employee distributor of mobile powered products, and their annual company meeting:

" Every November, the employees and their spouses are invited to an annual meeting at Burlington County College in New Jersey to discuss the company's position and strategy for the next year. A luncheon follows the meeting.

"They really get to see what's going on," Wilkinson said."

NewAge Industries (Southampton, PA)

The article also discusses NewAge Industries, a tubing and hose manufacturing company that we discussed in In the News: Celebrating Employee Ownership Month. CEO Ken Baker discussed the ""joyfulness" in the workplace" since the ESOP purchased 30% of the company in January 2006 and talked about how an ESOP makes it easier to sell a company:

"It's a lot easier to sell the company to someone else," Baker said. "It's a lot cleaner."